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Just made an interesting discovery, that led to an even more interesting discovery.

I’ve been watching the VIX calls, and in fact am very happily invested in the August 25’s at .50. Last night, someone pointed out that the in the money calls were trading below intrinsic value. A few minutes ago, with the index at 25, the August 20 calls were only trading at 3.

Strange, because arbitrageurs would normally not allow such a gap to exist. I talked to a trader friend of mine and, it turns out, VIX options trade off VIX futures. I’m not a futures trader, so I have to admit I didn’t know VIX traded in the futures markets.

But, it makes sense. With the cash index at 25 earlier today, the close-in futures contracts were about 3 points lower:

Aug 16: 21.60Sep 21: 21.65Oct 18: 22.40

I can’t get VIX futures on TOS, but CBOE has a quote webpage. Interesting, right?

But, that got me to thinking. What do futures traders know that I don’t? If futures prices are lower than cash, that reflects an expectation that prices are going lower. What about the big move down, the start of the next bear market, P[3], financial Armageddon, etc…

I decided to make a chart, looking at the premium/discount paid for futures prices vis-a-vis the cash market and SPX. This might be an interesting indicator, right?

I didn’t have to. Turns out the nice folks at CBOE already did it. They even covered the time period I’m most obsessed with interested in. Take a look.

The green line indicates whether the futures are trading at a premium (above the line) or a discount (below the line) to the cash index. ATL would indicate an expectation of increased volatility. BTL would indicate an expectation of decreased volatility.

Note how the discount/premium lines up with the blue line above, representing the SPX. In the above chart, we can see how the futures premium generally increases from early November into late December as SPX declines, then recovers to make some lower highs. They move inverse to one another, which is to be expected. A declining market should generate higher volatility premiums.

But, look what happened after that interim high (Dec 27). Even though the market drops pretty steadily, the VIX premium marches right along with it — no longer inverse.

Even though SPX had dropped from 1576 to 1406 in 31 trading days, that 170-point drop was all but forgotten when SPX rebounded by 92 points in 21 days. Investors figured the market had reached the bottom of its trading range and was making the next leg up, when in fact it was a corrective wave setting up for a new low.

VIX futures dropped to a big discount to the cash market starting on 12/26/07, just as the market began a decline that would total 228 points in less than a month.